The final benefit of mutual funds is daily liquidity, or the ability to rapidly turn an asset into cash. If you’ve ever had trouble selling a house or other illiquid asset, you know how useful liquidity can be. A mutual fund can be sold and turned into cash or invested into any other investments on any day the market is open.
Of course, mutual funds can have downsides as well. Obviously, when you give up control to a professional, you have less control as to when an individual stock or bond is bought or sold. However, the two main downsides are manager risk and fees. Manager risk is the risk that the manager picks the wrong stocks to buy and sell. Mutual fund fees can be excessive as well, including expense ratios of more than 1 percent of the assets in the fund each year, marketing fees, and commissions (called loads) for the salespersons who sell them. However, both of these risks can be minimized by investing only in no-load, low-cost, broadly diversified index mutual funds, such as those available from the mutual fund giant Vanguard. In these funds, the manager is essentially a computer who works very cheaply and just buys all of the stocks, guaranteeing the investors will receive the same return as the overall market.
The two main mutual fund structures investors will run into are traditional open-ended mutual funds and exchange-traded funds (ETFs). One is not necessarily better than the other; there are low-cost, well-managed funds of both types. The main difference is that a traditional mutual fund can only be bought and sold at the close of market each day, and an ETF can be bought and sold any time the market is open.
The most important consideration when evaluating mutual funds is the type of asset a mutual fund invests in. Mutual funds generally specialize in one type of asset, such as stocks or bonds. They may even subspecialize into specific types of stocks, such as utility or real estate companies. Mutual fund selection is often the final step in putting together a written investing plan. If the plan calls for you to invest in international stocks, you need to make sure the mutual fund you are looking at for that portion of the portfolio actually invests in international stocks.
After that, many investors are tempted to simply look for the fund with the best past returns. Unfortunately, this is such a poor method of choosing mutual funds that funds are required by law to tell you in writing that past performance is not an indicator of future performance. A much better predictor of future returns is the cost (or expense ratio) of the mutual fund. Over time, higher costs going to management erode into returns, leaving less for investors.